Close as it is to the historic and politically radioactive Old City of Jerusalem, when Naji Qafishi built his two-storey house in the Silwan district in 1994, he hardly expected it to be at the core of a global debate over the future of the Israeli-Palestinian conflict.

Even now, he is more worried about the impact of the demolition order for the property on the 14 people who live in its four rooms – his three sons, daughters-in-law and grandchildren.

"My grandson Naji, who is seven, came home from school yesterday. He got 96 in his test – and he said, 'Grandad, how will I be able to study if our house is destroyed?'"

"I felt very bad about what he said. He is only in the first grade," said Mr Qafishi, 54, an unemployed former building worker. Naji's mother, his daughter-in-law, had fallen into depression because of the threat to the home.

But Mr Qafishi – who walks most Fridays from his house in the Old City's historic basin to the Al Aqsa mosque 10 minutes to pray – is not alone. His house is one of 88 in Silwan's crowded Bustan neighbourhood to have been served with similar orders, to make way for an archaeological park and tourist site – or what one of the plan's opponents, the Israeli lawyer Daniel Seidemann, calls "something with the trappings of a Jewish evangelical theme park of the religious-nationalist right ... an ersatz biblical village."

This is no mere local zoning row. The largest planned demolition operation in Jerusalem since the Six Day War in 1967, it would trigger the eviction of 1,500 residents in what Palestinian officials say amounts to ethnic cleansing.

The project by the government, Jerusalem's mayor, Nir Barkat, and the settler organisations has become a potential flashpoint and the most imminent test of whether Arab East Jerusalem can ever become the capital of a future Palestinian state or remain entrenched in Israel, as the Prime Minister-designate Benjamin Netanyahu says he wants it to be.

Which is why on Wednesday the US Secretary of State Hillary Clinton said the demolition plans were "unhelpful", not in keeping with Israel's international obligations and a matter she would raise with the country's authorities. "It is clearly a matter of deep concern to those who are directly affected. But the ramifications go far beyond the individuals and the families that have received the notices," she said.

The Jerusalem municipality says most of the houses were built without permits, like Mr Qafishi's, although it has accepted the £585 council tax he has paid annually for the past 15 years. A spokesman for Mr Barkat said that "illegal building is illegal wherever it is."

But Mr Seidemann points out that while Israelis simply apply for a building permit, Palestinians have to undergo the "Sisyphean" process of submitting a detailed town planning scheme, only 125 of which were granted across all of East Jerusalem last year.

Mr Seidemann, the chairman of Ir Amim, which supports a pluralist, shared Jerusalem, says the planning regime has sought to preserve what the authorities call the "demographic balance" of Jerusalem – in other words "ensuring a solid Jewish majority".

It is not only houses built without permits that are threatened. Mohammed Badran, 47, shares his house with his two brothers and their families – 25 people in all. It was built in 1961, when the area was under Jordanian rule. Moreover he has the British mandate deed in the name of his great-grandmother to prove that the land has been in his family for more than 80 years. What's more, the Badran brothers not only pay more than £1000 council tax a year, they have spent most of their working lives employed by the municipality which now wants to evict them.

Mr Badran successfully fought a previous demolition order in the courts four years ago, foregoing an expensive computer for his blind son to pay the lawyers' fees. But the family says the stay of execution was granted only on condition that the plans to build a park in Bustan did not go ahead.

The purpose of that plan from 2005, which now threatens to become a reality for the Badrans, was officially described as to "strengthen Jerusalem as the capital of Israel". The plan is to develop the historic basin and the Mount of Olives above it at a cost of £66m. The development provides for a cable car running from the Old City possibly to the Mount of Olives and what Mr Seidemann says are "escalators running through the most important archaeological site on the planet".

Mr Seidemann believes the plan is "dangerous" to the city's stability and potentially fatal to a two-state solution. He says for all its encroachments in East Jerusalem since 1967, Israel has always treated the religious and cultural "complexity of this area with a good deal of reverence. But this is a clear departure from maintaining the cultural and religious integrity" of the city.

He believes the plan could ignite the city, as did the building of a tunnel from the Western Wall to the Muslim quarter, which caused lethal rioting, and the walk Ariel Sharon took on the Temple Mount/Haram al-Sharif, which helped to trigger the second intifada. Beyond that, he says it could even to turn a basically political and territorial conflict into a fundamentalist religious one.

Its impact on a peace deal could be just as devastating, not least because it could create a new humanitarian refugee problem of profound significance, however historically small in scale, because of its location.

"This is a deal breaker," says Mr Seidemann. "There will not be a peace agreement under any kind of foreseeable circumstances [for] 10, 20, 30 years, [if you create] a new category of Palestinian refugee. I consider the settler activities in Silwan to be a highly disproportionate strategic threat not only to the nature of the conflict and the viability and character of the city but also to a two state solution."

Mr Badran's concerns are more immediate. "This is the house where I was born. I am attached to Silwan." Although a Muslim, he adds: "The water of Silwan is the holy water Jesus used to heal a blind man."

The municipality has raised the possibility of compensation but like Mr Qafishi, he says he will not accept it and adds he turned down a $10m offer for the house 12 years ago. He refers to Mayor Barkat's description of Bustan as "The Valley of the King" and says: "Would King David have agreed to have me evicted from my house to build a garden in his name? I don't think so."

Bulldozer 'terrorist': Driver shot dead

A Palestinian driver crashed his bulldozer into a police car and a bus at one of Jerusalem's busiest road junctions yesterday before police and a taxi driver shot him dead.

An open Koran was found in the "terrorist" driver's cabin, a police spokesman told reporters. The driver was identified as Marei Radaydeh, a West Bank construction worker in his mid-20s who lived with his family in the Arab East Jerusalem neighbourhood of Beit Hanina.

Hamas said the attack was a "natural response" to Israel's demolition of Palestinian homes in East Jerusalem and to the Israeli military offensive in the Gaza Strip.

The bulldozer first turned over a police car, injuring two officers inside, and then slammed the car into a bus before the attacker was killed. No one on the bus was hurt. reuters